The Three Things Needed to Create a Virtuous Economic Cycle

If the White House's economic recovery program – the $787 billion stimulus plan -- and the Fed's near-zero interest rates were working better, we would see robust job growth and rising prices. Instead we have job losses and deflation fears, although Friday's inflation report may cool those fears somewhat. To turn this around, we need to know why these programs aren't working, and then take action to counter these causes.

Since January 2009, the White House has argued that these efforts, coupled with its $50 billion investment to rescue GM from liquidation, have saved or created millions of jobs. According to The White House Council of Economic Advisers, through the first half of 2010, $100 billion of that stimulus money had been spent, saving or creating 3.6 million jobs. Despite that, there are millions fewer jobs now than there were when the current recession began in December of 2007.

True, without these programs, the economy would almost certainly be in worse shape than it is. But their failure to revive economic growth more significantly raises questions about how well they're working.

I think three things need to happen to create a virtuous economic cycle in which growth leads to hiring, which leads to higher demand and more growth. The failure of the economic stimulus plan to prime this growth pump reveals what needs to be fixed. To create such a cycle, here's what needs to happen:

Companies need to hire American workers. In July, 131,000 jobs were lost and the unemployment rate remained at 9.5%. Companies aren't eager to hire workers on a full-time basis because for now they figure they can get the productivity they need without adding to their fixed costs by taking on permanent employees. As much as politicians would like them to, companies don't work for leaders who want them to hire people so they can get reelected. CEOs report to shareholders, who expect their companies to beat quarterly earnings forecasts and raise financial outlooks, and to debt holders, who expect them to make their loan payments on time. Since American workers account for 71% of GDP growth (up from 70% since before the recession), companies need to hire them to get the boomerang effect of their salaries creating more demand for their products.

Lenders must grant consumers cheap debt. According to Newsweek, plenty of money is out there to be loaned, but consumers who need it most -- the ones whose houses are worth less than the amount they owe the banks and those who are out of jobs -- lack the credit scores needed to quality for the money. I'd like to think we can find a different way to get economic growth rising besides letting consumers borrow and spend. Unfortunately, I don't see an obvious way to revive growth here until those consumers get the extra cash they need to buy more. Ultimately, I would like our economy to be much more dependent on companies investing in technology that boosts their economic performance.

Institutional investors must provide capital for start-ups. Bloomberg reports that institutional investors are demonstrating a new eagerness to buy corporate debt. This suggests that those investors are growing slightly more willing to take risks after spending much of the last few years pouring money into government bonds that offer extremely low yields while preserving capital. Investors' appetite for this debt means that companies will hoard their cash -- a $1.84 trillion stash according to the Federal Reserve -- to make sure that they can service the new bonds they're selling. But with venture capital returns having run negative and those institutions remaining gun shy on risk, not much new money will be going into venture capital funds for some time. Nevertheless, these are problems that vibrant markets for venture-backed initial public offerings could solve.

The key question is how to make these things happen. My view is that with the right economic incentives, companies, lenders, and institutional investors will do the right things. Whether government has a role here isn't settled yet. It could tweak incentives for all these economic actors to nudge them in the right direction. But ultimately, the best people to make the microeconomic decisions to create growth must decide that the benefits of pro-growth initiatives outweigh the costs.